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How to build a second income stream on the cheap

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Never depend on single income,” Warren Buffett once said. It’s seriously good advice. Not only does having a second stream cushion any blows that may come from any unexpected interruptions to the first, the extra cash generated can also put you firmly in the driving seat when it comes to building a sizeable nest egg.

Unfortunately, many of the ways of generating extra money require quite a bit of effort. Becoming a landlord seems a great idea until you’re unlucky enough to have to deal with problematic tenants. Selling things on eBay can be lucrative but it’s easy to forget that you’ll also need to package and post items (and perhaps deal with the odd complaint).

The crux of the matter: how to generate the most income from the least effort. The solution? The stock market, of course.

Grab those dividends

As far as building a second income stream goes, creating a portfolio packed full of dividend-paying firms takes some beating. Right now, many of the UK’s biggest companies are offering enticing payouts. Royal Dutch Shell, Lloyds Banking Group and Aviva, for example, are expected to yield 5.9%, 6.2% and 5.8% respectively this year.

There are a few disadvantages to the above strategy, however. 

First, it requires the individual investor to fully research the companies they invest in. That’s no problem if you enjoy getting down and dirty with company XYZ’s latest set of results and balance sheet. It’s not for everyone though.

Second, buying stock in a single company increases capital risk — the chance that you will lose your money. If revenue and profits dip, dividends will often be the first things to be sacrificed by management. And when dividends are cut, a company’s price drops as investors run for the exits.

Third, buying shares in individual businesses can cost a lot if you have a tendency to buy them on a whim. In addition to the commission charged by your broker, you’ve also got to consider stamp duty and the bid/offer spread. The latter can be rather big if you’re thinking of purchasing dividend-paying firms at the lower end of the market spectrum.

For those less inclined to follow the markets, let alone specific stocks, there’s a better solution.

A cheaper option

Exchange-traded funds are ideal options for those looking to build a second income stream on the cheap. Not only do they give an investor instant diversification, the ongoing charges are almost invariably lower than any funds actively managed by an arguably overpaid human.

While not paying as much as some individual companies, the payouts from these passive vehicles are still attractive. The iShares Core FTSE 100 ETF, for example, currently yields 4.2% and — importantly — has a total expense ratio of just 0.07%. Alternatively, its UK Dividend ETF offers 5.6% for a 0.4% ongoing charge. That’s seriously good value compared to the 1%-2% fees often charged by money managers, many of whom end up replicating the market in an effort to avoid being fired. Simply take advantage of regular investment plans, pay less, sit back, ignore the noise and let the money roll in.

Of course, what you choose to do with your second income stream will depend on your financial goals. By far the best solution for those with time on their hands, however, is to reinvest what they receive straight back into the market.

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Paul Summers has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.